Desperately Seeking Kuznets

What goes up …

In 1955, the economist Simon Kuznets[1] put forward the hypothesis that, as an economy develops, market forces first increase, then decrease inequality – or at the least, that is what many suppose his hypothesis to be.

Kuznets’ analysis considered data from the USA, the UK and Germany, and he concluded that there were two drivers of increasing inequality – the concentration of savings in the upper income brackets (in other words, the wealthy can afford to save, and therefore invest more than the vulnerable) – and the disparity in incomes between urban and rural workers. However, Kuznets argued, as an economy develops inequality will eventually decrease. This postulated inverted “U” shape became known as the Kuznets Curve.

Other economists have similarly argued a Kuznets’ style effect in pollution[2], a so-called Environmental Kuznets Curve. This hypothesis suggests poor nations have no alternative but to increase, for example, green-house gas emissions as they industrialise. However, as they become more wealthy, nations can afford to “invest” in a cleaner environment; therefore emissions will stabilise and decline.

Kuznets’ original analysis appears to justify the speculation of Adam Smith[3] who argued:

They [the rich] are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants

the free market system distributes the fruits of economic progress among all people

What goes down …

Others beg to differ from this optimistic point of view. Winston Churchill, for example, wryly commented[5]

The inherent vice of capitalism is the unequal sharing of blessings

Mind you, that not mean we should dispense with capitalism; as he also noted:

the inherent virtue of socialism is the equal sharing of miseries.

Recent evidence is rather on the side of the naysayers. Rather than an inverted “U” shape, in the English speaking world at any rate, there is evidence that inequality first declined then increased over the last century. (Those readers of a New Zealand persuasion might like to speculate what happened in 1999 which might have disrupted this trend).

Similarly, while there is some evidence nations are relatively less focussed on heavy industry as they become more affluent, however on a world scale affluent nations cause more pollutants to be emitted (per capita) than poorer nations[6], there is no significant evidence of an Environmental Kuznets Curve. In general developed nations are relatively successful in out-outsourcing their carbon footprint (that is, relocating polluting industries to less well developed nations): this is, of course, not the same as reducing their carbon footprint.

The externalities of growth

It would seem that economic growth is no panacea to the problems the free-market produces. This is because pollution and inequality are what economists would call negative externalities; unwanted side-effects of otherwise desirable activity. Simple economic theory shows, where a market produces externalities, that market fails to be efficient and may even become unsustainable.

From economy to political economy

We come, however, to praise Kuznets, not to bury him. The unforeseen increase in inequality does not disprove his hypothesis, merely the interpretation that some commentators put on it. Kuznets did not suggest it was solely economic forces which reduced inequality, but rather political-economic forces. For example, as nations prosper, workers unionise, and demand that government acts to reduce the externalities (including inequality) which arise from capitalist industrialisation. In democratic nations, voters may likewise pressure their representatives to ensure the benefits of growth do not accrue disproportionally to the economically powerful.

It may well be that the events of the 1980s, the decade which saw inequality reverse its decline and begin once again to increase, were triggered not by economics, but rather by political change. At this time many Western nations adopted policies based on what is sometimes called the Washington Consensus (sometimes also known as monetarism or neo-liberalism). It should be noted that, in their original form, many of the policy prescriptions of the Washington Consensus made good economic sense. Over time, however, those policy prescriptions tended to emphasise limiting the power of democratic governments.

As Western governments sought to limit their own powers (and, to limit the power of trades unions), so the democratic check on the increase in inequality became undermined; the drivers of the downwards part of Kuznets’ postulated curve were removed and inequality once again began to increase. Conversely, those nations which tended rather to emphasise the social-democratic role of government were less likely to see an increase in inequality. It is worth noting that many of these nations began the 20th century with even more unequal distributions than the UK.